The Economic Forecast: Headwinds Ahead

Three economic criteria have dominated the world economy since the crash in 2008: the Central Banks have been mandated to maintain low inflation – not more than 1.5% – , Quantitative Easing and extremely low interest rates. All had one objective in mind: to ease the economy gently and gradually out of depression and to stimulate growth. The result has been continued deflation in consumer prices, moribund inflation while asset prices have surged. This scenario is unsustainable and will have consequences in the near future.

After galloping inflation in the nineteen seventies – the culmination of decades of Keynesian policies – inflation rates ratcheted up. The stimulant effect of the drug benignly known as inflation now presented deleterious effects. Drastic action was called for. Easy money flowed into unsustainable or delinquent assets such as leviathan but unproductive such as British Steel, British Airways and British Coal. No longer was the propping up of bloated uncompetitive entities viable.

The Western World changed tack. With Reagan & Thatcher gaining power, the focus shifted from Keynesian to free markets and monetarism as espoused by Milton Friedman.

As an aside, Friedman’s interests were more expansive than economics to embrace societal freedom. In his seminal 1962 book Capitalism and Freedom he advocated such policies as a voluntary military, school vouchers and freely floating exchange rates.

John Maynard Keynes- the father of Keynesian economics

Friedman’s challenged what be referred to as “naive Keynesian” (as opposed to Neo-Keynesian) theory. After reinterpreting the consumption function during the 1950’s, during the 1960s, he promoted an alternative macroeconomic policy known as monetarism. Amongst other things, he theorized that there existed a natural rate of unemployment and argued that governments could only increase employment above this rate, e.g., by increasing aggregate demand, only for as long as inflation was accelerating. The world took note when his prediction of stagflation arose with ferocious destructiveness. [Per Wikipedia: Stagflation, a portmanteau of stagnation and inflation, is a term used in economics to describe a situation where the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high.]

Milton Freidman

From being the sick man of Europe economically, Thatcher altered the economic trajectory through determination conflated with a huge dollop of luck – the Falklands War as a distraction and the North Sea oil as a bonanza – to validate Friedman’s policies.

These policies were gradually relaxed over the years. From the mid-nineties, the spectre of inflation had been vanquished. With 20 years of unremitting growth, a new cohort of entrepreneur with threadbare business plans and acumen attracted the attention of the investors and banks. With their chant that the internet would revolutionise business, even the most outlandish ideas received financial backing. Price Earnings Ratios – PE Ratios – were atmospheric with many being in excess of 100.

All the hallmarks of a classical asset price bubble were in the making. This feeding frenzy continued over the millennium. In 2008, the market rebelled. Asset Valuations plummeted and fortunes were lost.

By then Japan had already experienced a unique phenomenon which the world had not encountered since 1929: Deflation. The world was incapable of handling its pernicious and ruinous effects.

In order to stimulate demand, the only weapon in the armoury of the Central Reserve Banks of the major economies was reducing interest rates. The shrinking rates did mitigate the worst of the effects of the banking crisis but what it lacked was the impetus to generate growth.

The Central Banks then devised what was disingenuously termed Quantitative Easing, a sophisticated term for printing billions of dollars of money. Even Abe Shinzo in Japan tried this supposed panacea.

The succinct objective of Quantitative Easing was to print money in order to increase demand for goods and services. This would in turn create inflation which would reverse the effects of deflation.

This policy has been a brilliant success in stimulating demand but instead of its intended target, it has seen the explosion of asset prices.

Incipient asset bubble ripe for the pricking

This is the elephant in the room.

With the Central Bank’s singular focus on maintaining inflation at less than 1.5%, how do they sell the fact that interest rates have to be raised? The Central Bank Governors face a conundrum. If they do nothing, the Asset Bubble will inexorably burst with all its attendant negative economic consequences. If they do raise interest rates albeit gingerly, they will in all likelihood precipitate a market crash!

PE Ratios in Japan based upon averaged earnings over 10 years

Equities are severely overvalued world-wide. Hence a correction is long overdue.

Once the first whiff of correction arises, the whole edifice will crumble.

In the long term, politics and sentiment cannot irrationally prop any prices.

In my case, the effect will be on my pension portfolio which has been growing at a steady clip to the point where I consider that I might be able to retire comfortably.

In accordance with the laws of economics, nothing anybody does can postpone it for another 30 years when I am dead.